Traditionally residential mortgage lending has involved a two-fold evaluation of the loan repayment ability of prospective homeowners and mortgage applicants. This process encompasses a simultaneous assessment of: 1)payment affordability (i.e., the percentage of application income required to make monthly mortgage payments) and 2)underlying collateral value in case of foreclosure and resale (i.e., Loan-To-Value ratios: the ratio of principal obligation to appraised house value ). Together, these factors have formed the credit risk of mortgage lending.
Before the last two decades, mortgage lenders assumed that fixed mortgage loan payments, calculated at fixed nominal rates of interest over typical fives of fifteen to thirty year loans, would provide them a fixed, but reliable, financial return on their capital. These lenders implicitly relied upon a continuation of low and stable inflation and interest rates over the entire life of their mortgage loans.
Events during the 1970s, however, dramatically altered this assumption. The market value of outstanding mortgage loans, with their lower and fixed rates and long maturities, were now seriously eroded by enormous surges in inflation and interest rates during this period. Tied into fixed low interest-bearing loans over extended repayment periods, lenders discovered a new financial return, or interest rate, risk now inherent in all mortgage lending.
At the same time, moreover, house prices increased dramatically, not only as an immediate result of inflation, but as a perfect hedge against further inflation. Prospective new homeowners now faced the prospect of dramatically larger and typically unaffordable mortgage payments. This resulted, not only from the repayment of higher principal balances on much higher-priced housing, but the compounding effect of higher mortgage interest rates on the higher mortgage principal. Since fewer people could afford these higher payments, fewer prospective homeowners could meet the credit (or affordability) criteria of mortgage lenders.
A number of new mortgage instruments, generally termed Adjustable Rate Mortgages (ARMs), arose that shifted the interest rate risk to borrowers, but did not solve the real financing problems. Lenders, faced with the uncertainty of future inflation and interest rates eroding the value of prospective loans, offered mortgages wherein monthly payments would vary based upon changes in future interest rate indices as generally tied to federal fund rates. These instruments used the indices as proxies for adjustments to new levels of interest cost owed and payable by the homeowner or, equivalently, rates of return required by the lender.
One kind of instrument, the Shared Appreciation Mortgage (SAM), transferred the interest rate risk to homeowners by offering fixed lower interest rates and monthly mortgage payments in return for a share in any appreciation in the mortgaged house. The lender, however, did not reciprocally share with the homeowners any losses on the value of the house over the mortgage duration.
These mortgages proved unmarketable for several reasons. First of all, the SAM required a costly and uncertain specific house appraisal to determine the lender's share, if any, of appreciation after forced refinancing in ten years. Secondly, the homeowner had to refinance, not only the remaining mortgage principal, but original lender's share of appreciation. Finally, the homeowner had no way of fixing, at the inception of the SAM mortgage, his monthly mortgage payment obligations after the initial ten year refinancing.
None of these new mortgage instruments, however, have done anything to address the underlying mortgage financing problems of insuring: 1) low and affordable monthly mortgage payments, 2) certainty in the mount of those payments over the life of the loan and 3) adequate financial returns to mortgage lenders in all future inflation and interest rate environments.
First of all, neither conventional fixed rate or ARM instruments provide a mechanism for actually funding higher borrowed principal and interest rates with lower monthly payments. As such, they cannot solve the first and most important problem, affordability.
Conventional fixed rate mortgages and ARMs alternately solve the second and third problems, but only by exacerbating the other. Fixed rate mortgages guarantee fixed payments, but only by exposing the lender to the interest rate risk over the lives of these loans. And while ARMs partially guarantee financial returns, they do so only by exposing the borrower to unknown and perhaps unaffordable future mortgage obligations. Therefore, certainty (against interest rate risk) for lenders (through ARMs) means uncertainty in payment for borrowers. And certainty in payment for borrowers (through fixed rate mortgages) means uncertainty (or interest rate risk) for lenders.
Moreover, ARMs can only really partially shift the interest rate risk and uncertainty to borrowers for several reasons. First of all, ARMs can be unmarketable in interest rate environments generally perceived as temporally low relative to the anticipated future. Just when lenders want interest rate protection against the future, borrowers baulk at the prospect of higher future payments under ARMs. Secondly, even if borrowers accept these loans, they may be unable to make higher monthly payments in the future. As such, the lender may be forced to foreclose and resell the house at a loss in the very housing finance market that led to original foreclosure. Finally, mortgages are uniquely homeowner, not lender, callable. After making modest penalty payments, the homeowner can refinance the mortgage loan in interest rate markets of his own choosing. The lender has no such equal election. In mortgage capital markets, this creates what is termed "negative convexity:" i.e., high rates of return do not persist (because of homeowner refinancings), while low rates do (because of fewer sales and no refinancings).
It is the primary object of the invention to create a process and method which simultaneously solves all of the home financing problems as outlined above. The invention accomplishes this by uniquely separating the legal notion of "ownership" between that of rights to "use and possession" and "equity investment." In mortgage agreements created with the subject invention the homeowner retains the traditional right of use and possession. But he now immediately surrenders a fixed equity share in the house to a new Joint Venture Partner (JVP). The invention is a system to calculate the estimated future value of the JVP share and other payments from inception of the loan through termination in order to assure a financial rate of return sufficient to attract mortgage investors (mortgagees).
The Joint Venture Partner is one of two sources of mortgage capital now financing homeowner purchase. Under a new single first mortgage (with a "cross default" provision in the case of foreclosure) there are two separate sections. The first, Section A, is a conventional mortgage loan (i.e., fixed rate mortgage or, alternately, an ARM). Section B is the homeowner's new Joint Venture Partner, who, in return for partial financing, obtains a substantial and fixed share in the value of the house from inception to termination of the agreement. At the end of the agreement (through sale, normal termination or foreclosure), the homeowner repays his Joint Venture Partner for his share of the house.
The instruments produced under the new invention simultaneously lower payments, fix amounts throughout the life of the new mortgages, and allow the homeowner to effectively defer some of the payment to termination. Since the latter mount will vary based upon the level of inflation and house prices during the course of the agreement, this also insures that the financial return on the JVP's investment reflects actual investment requirements. If inflation is high, the JVP will receive a larger amount. If low, the JVP receives a lower amount. As mutual investors, however, they both have an interest in house appreciation. Their interests are not competing as under conventional fixed vs. ARM loans, but fully aligned.
It is a further object of the invention to create a new two- section single first mortgage, which creates two new investment vehicles in one instrument. While the mortgage capital source can purchase and hold both Section A and B of the single mortgage, they can also be sold separately or accumulated as the collateral for mortgage-backed securities. The Section A pan is ideal for traditional mortgage capital sources because it embodies the elements of conventional loan agreements. Section B is ideal for long-term investors, such as pension funds, who want long maturities with hedges against erosion in investment values due to inflation.
It is another object of the invention to restabilize all aspects of the residential construction and financing markets. Alternate "booms" and "busts" currently plague these industries because small changes in interest rates dramatically expand or alternately contract the pool of prospective homeowners. Builders commencing construction in low interest rate markets often are forced to sell houses quickly and at a loss to repay construction loans after rates have increased during construction. Similarly, homeowners often cannot sell their houses at all during these periods of high interest rates.
The invention solves this problems by largely insulating prospective homeowners from current interest rate levels. Both home builders and home sellers now have the opportunity to become Joint Venture Partners with prospective buyers by effectively repurchasing a share in houses financed through this mortgage. Instead of absorbing losses under forced sale, they temporarily repurchase and equity interest and can resell the JVP Section equity to permanent investors.
It is still another object of the invention to facilitate new ownership opportunities for renters by effectively lowering the operating costs of landlords. Currently, landlords must set rents at levels to cover both costs of maintenance and upkeep and damage upon lease expiration. Under mortgages created by the new invention, these costs are either eliminated or willingly absorbed by the current renters (or new owners), who are newly invested in the upkeep and future value of the occupied property. As such, this invention provides a more cost-effective and affordable ownership option to renters than traditional condominium conversion. The above also applies to landlords who rent single family dwellings as well as commercial real estate.